Dividend payout and executive compensation: theory and Canadian evidence

Abstract

Purpose This paper seeks to present and test a model of the association between dividend payout and executive compensation. Design/methodology/approach The authors develop a model based on Bhattacharyya whereby managerial quality is unobservable to shareholders, and therefore first‐best contracts are not possible. In the second‐best world, compensation contracts motivate high quality managers to retain and invest firm earnings, while low quality managers are motivated to distribute income to shareholders. These hypotheses arising from the model are tested on data for Canadian firms' dividend payouts over the period 1993‐1995 using tobit regression analyses. Findings Consistent with the predictions of the Bhattacharyya model, the results show that, ceteris paribus , earnings retention (dividend payout) is positively (negatively) associated with executive compensation. These results hold when payout is defined as common dividends plus common share repurchases. Research limitations/implications The Canadian data provide only limited information on the components of executive compensation. A more useful test would be possible with more detailed information on, for example, salary, bonus, and benefits. Originality/value Several recent papers have documented an association between dividends and executive compensation. This paper presents and tests a model that provides a potential explanation for this link.